FinanceFinancial Education

Understanding Mutual Funds & ETFs

Mutual funds and ETFs (exchange-traded funds) are pooled investments that allow individuals to combine their money with others for the benefit of buying larger numbers of individual investments from different sources (diversification).  The promised benefit of greater diversification is less risk since the fund or ETF is less susceptible to the ups and downs of single-investment ownership. Although they are similar in this respect, they have stark differences, as well.

The most notable difference is the way they are purchased and sold. Most mutual funds have some form of sales charge, even no-load funds, whether assessed when the fund is initially purchased, when sold or ongoing (12b1 fees). ETFs are traded like stocks in that the broker assesses a transaction fee upon purchase or sale rather than a sales charge. In addition, mutual funds are traded for their net asset value (NAV) when the market closes, whereas, ETFs are traded in real time throughout the day. Finally, mutual funds typically have minimum funding requirements. ETFs allow an investor to buy as little as one unit.

There are potential differences in annual tax treatment, as well, due to the way they each handle asset turnover (sale versus like-kind exchange). However, there is ultimately no way to escape paying taxes on the gains when the investor liquidates, so the difference regarding annual tax liabilities is negligible in the long run.

Without getting into a full-blown lesson regarding Modern Portfolio Theory and the interaction of different asset classes, coefficients of risk, and the Efficient Frontier, it is important to understand the way mutual funds and ETFs are managed, and how management style can directly impact portfolio performance.

Without getting into a full-blown lesson regarding Modern Portfolio Theory and the interaction of different asset classes, coefficients of risk, and the Efficient Frontier, it is important to understand the way mutual funds and ETFs are managed, and how management style can directly impact portfolio performance.

If an investor wishes to purchase a mutual fund or ETF to satisfy a specific diversification goal, say large-cap stocks or high yield corporate bonds, they are typically doing so for the express purpose of portfolio balance and risk/return management. What happens if the manager is allowed to “chase returns” by misallocating a predefined portion of the underlying portfolio into an unrelated asset class? On the surface, this may appear to be sound management, but it may (1) prove unsuccessful, and (2) distort the integrity of the investor’s portfolio balance. Mutual fund managers are notorious for this type of style drift. ETFs managers are not.

With all of their similarities and differences, the single factor each investor should understand before investing is that their principal is at risk of loss…period. There is no guarantee of principal for investment loss in these vehicles. There may be opportunity for high yielding gains, but there is equal opportunity for damaging losses.

Before making an investment decision, it is critical advisors and clients alike understand all of the options and potential pitfalls, especially when alternatives are available that offer upside potential with no downside risk. But, that is a topic for another day… Stay tuned.

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